Despite the Swiss central bank’s efforts to drive the Swiss franc lower last week, with its dovish assessment of Swiss growth as well as its downgrade to Swiss inflation, the currency will still bounce back.

First, the franc is still being driven by investment flows that will continue in its favor. And second, even though the SNB may have postponed any rate hike plans for now, the Swiss central bank will still likely raise its interest rates well before the European Central Bank.

Just look at the tiny four-basis-point narrowing in the two-year bond yield spreads between the franc and the euro after the SNB’s monetary policy statement. This small move hardly justifies the sharp rally in which the euro made its largest one-day gain against the franc since May. Read SNB’s most recent monetary policy data statement here.

Of course, optimists are hoping that the SNB’s decision to slash its 2011 growth forecasts and warn that deflation could return will be enough to overturn the Swiss franc’s fortunes.

Calling time on the Swiss franc rally. At the moment, there is still plenty of reason for bulls to continue buying the Swiss currency. The Swiss economy continues to outperform its neighbors and uncertainty over the global recovery makes the franc attractive as a safe haven.

Look at the other major safe haven, the yen. The Japanese currency managed to hit a new 15-year high against the dollar as soon as Japanese Prime Minister Naoto Kan was confirmed prime minister after leadership elections in the ruling party this week. The yen is expected to remain strong, even though the Bank of Japan has now stepped in to stop its advance with the first direct market intervention in six and a half years.

The franc itself hit a record high against the euro only a week ago–at CHF1.2765–and rallied back over parity against the dollar for the first time in nearly 10 months on Tuesday.

But this could well prove to be the last of the franc’s rally. Not only is the currency’s safe-haven role likely to become less urgent, once the global recovery regains its traction, but the Swiss authorities are likely to become less tolerant of a strong currency as the Swiss economy itself shows signs of slowing.

A few months ago, the Swiss National Bank was buying euros on a massive scale to try and stop the franc from climbing. Read my earlier post here.

Now, if the gossip among traders is to be believed, it’s selling some of those euros in favor of other currencies, and indirectly pushing the franc back up to record highs. Ouch.

The story goes like this:

Keen to prevent the soaring Swiss franc from generating a spiral of deflation in the opening months of this year, the SNB gorged on euros, buying them on an unprecedented scale.

It kind of worked; who knows how high the franc would have climbed if the SNB hadn’t intervened? Still, though, the franc ground higher and higher, until the SNB stepped away from the market and the euro hit an all-time low of CHF1.3073 on July 1.

Now, the SNB is left holding quite a bit more than a fistful of euros. From time to time, traders say it recycles them into other currencies, pushing the euro lower.

Friday, traders and analysts said it was selling euros again, and several cited those flows as a key reason for the euro’s rapid decline against the dollar. In line with its normal policy on day-to-day currency moves, the SNB itself declined to comment.

The twist this time, though, is that this little tumble in the euro against the dollar quickly morphed into a little tumble across the board, including against the Swiss franc.

Now, all of a sudden, the market appears to be heading for a fresh record high in the franc, with the euro dipping to CHF1.3105 Monday. Talk of euro selling by the SNB is not the only reason for this by any stretch of the imagination. But it is one.

And it’s buying up foreign bonds on such a scale that it could start making awkward demands of other major global political powers.

China?

No. Switzerland. Neutral, little, mind-our-own business Switzerland.

Bloomberg

Swiss bank notes and Swiss franc coins.

The country’s efforts to stop the Swiss franc from climbing too fast last year seemed fair enough. It’s a relatively small economy, very dependent on exports, and a rapid climb in the currency could be tough to take. The Swiss National Bank‘s occasional blasts of euro buying to push the franc back down had little impact beyond its borders.

Fast forward to now, though, and the whole situation appears to have got out of hand. Data released Tuesday showed that the SNB spent the equivalent of 15% of the country’s entire gross domestic product building up reserves in May alone, desperately trying to stop the crumbling euro from falling against the franc.

It didn’t even really work. The franc kept on climbing as investors are so desperate for safe havens right now, and this is the region’s premier hideaway currency in times of stress.

Total reserves now stand at around CHF232 billion, or $200 billion, marking an accumulation equivalent to 45% of GDP since the end of last year.

Granted, that’s some distance behind China’s $2.4 trillion in reserves that it held by the end of 2009. But it’s right up there with South Korea, Hong Kong and Brazil. In Europe, only oil-rich Norway and Russia have bigger reserves; it dwarfs every other country in the region.